Solution manual for essentials of corporate finance 7th edition by ross download

For a successful company that is rapidly expanding, capital outlays would typically be large, possibly leading to negative cash flow from assets.. The income statement starts with reven

Solution Manual for Essentials of Corporate

Finance 7th Edition by Ross

CHAPTER 2

Answers to Concepts Review and Critical Thinking Questions

1 Liquidity measures how quickly and easily an asset can be converted to cash

without significant loss in value It’s desirable for firms to have high liquidity

so that they can more safely meet short-term creditor demands However, liquidity also has an opportunity cost Firms generally reap higher returns by investing in illiquid, productive assets It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing

needs

2 The recognition and matching principles in financial accounting call for

revenues, and the costs associated with producing those revenues, to be

“booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid Note that this way is not necessarily correct; it’s the way accountants have chosen to do it

3 Historical costs can be objectively and precisely measured, whereas market

values can be difficult to estimate, and different analysts would come up with different numbers Thus, there is a tradeoff between relevance (market values)

and objectivity (book values)

4 Depreciation is a non-cash deduction that reflects adjustments made in asset

book values in accordance with the matching principle in financial accounting

Interest expense is a cash outlay, but it’s a financing cost, not an operating cost

5 Market values can never be negative Imagine a share of stock selling for –$20

This would mean that if you placed an order for 100 shares, you would get the

stock along with a check for $2,000 How many shares do you want to buy?

2-1

More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value

6 For a successful company that is rapidly expanding, capital outlays would

typically be large, possibly leading to negative cash flow from assets In general, what matters is whether the money is spent wisely, not whether cash

flow from assets is positive or negative

7 It’s probably not a good sign for an established company, but it would be fairly

ordinary for a start-up, so it depends

8 For example, if a company were to become more efficient in inventory

management, the amount of inventory needed would decline The same might

be true if it becomes better at collecting its receivables In general, anything that leads to a decline in ending NWC relative to beginning NWC would have this effect Negative net capital spending would mean more long-lived assets

were liquidated than purchased

9 If a company raises more money from selling stock than it pays in dividends in

a particular period, its cash flow to stockholders will be negative If a company borrows more than it pays in interest, its cash flow to creditors will be

negative

10 The adjustments discussed were purely accounting changes; they had no cash

flow or market value consequences unless the new accounting information

caused stockholders to revalue the company

11 The legal system thought it was fraud Mr Sullivan disregarded GAAP

procedures, which is fraudulent That fraudulent activity is unethical goes

without saying

12 By reclassifying costs as assets, it lowered costs when the lines were leased

This increased the net income for the company It probably increased most future net income amounts, although not as much as you might think Since the telephone lines were fixed assets, they would have been depreciated in the future This depreciation would reduce the effect of expensing the telephone lines The cash flows of the firm would basically be unaffected no matter what

the accounting treatment of the telephone lines

Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet Many problems require multiple steps Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred However, the final answer for each problem is found without rounding during any step in the problem

Basic

1 The balance sheet for the company will look like this:

Current assets $2,170 Current liabilities $1,350

Net fixed assets 9,300 Long-term debt 3,980

Total liabilities &

The owner’s equity is a plug variable We know that total assets must equal total liabilities & owner’s equity Total liabilities and equity is the sum of all debt and equity, so if we subtract debt from total liabilities and owner’s equity, the remainder must be the equity balance, so:

Owner’s equity = Total liabilities & equity – Current liabilities – Long-term debt Owner’s equity = $11,470 – 1,350 – 3,980

Owner’s equity = $6,140

Net working capital is current assets minus current liabilities, so:

NWC = Current assets – Current liabilities

NWC = $2,170 – 1,350

NWC = $820

2 The income statement starts with revenues and subtracts costs to arrive at

EBIT We then subtract out interest to get taxable income, and then subtract

taxes to arrive at net income Doing so, we get:

Net income = Dividends + Addition to retained earnings

Addition to retained earnings = $131,950 – 36,000

Addition to retained earnings = $95,950

4 Earnings per share is the net income divided by the shares outstanding, so:

EPS = Net income / Shares outstanding

EPS = $131,950 / 40,000

EPS = $3.30 per share

And dividends per share are the total dividends paid divided by the shares outstanding, so:

DPS = Dividends / Shares outstanding

DPS = $36,000 / 40,000

DPS = $0.90 per share

5 To find the book value of assets, we first need to find the book value of current

assets We are given the NWC NWC is the difference between current assets and current liabilities, so we can use this relationship to find the book value of

current assets Doing so, we find:

NWC = Current assets – Current liabilities

Current assets = $130,000 + 710,000 = $840,000

Now we can construct the book value of assets Doing so, we get:

Book value of assets

6 Using Table 2.3, we can see the marginal tax schedule The first $50,000 of

income is taxed at 15 percent, the next $25,000 is taxed at 25 percent, the next

$25,000 is taxed at 34 percent, and the next $175,000 is taxed at 39 percent

So, the total taxes for the company will be:

Taxes = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($275,000 – 100,000)

Taxes = $90,500

7 The average tax rate is the total taxes paid divided by net income, so:

Average tax rate = Total tax / Net income

Average tax rate = $90,500 / $275,000

Average tax rate = 3291 or 32.91%

The marginal tax rate is the tax rate on the next dollar of income The company has net income of $275,000 and the 39 percent tax bracket is applicable to a net income up to $335,000, so the marginal tax rate is 39 percent

8 To calculate the OCF, we first need to construct an income statement The

income statement starts with revenues and subtracts costs to arrive at EBIT

We then subtract out interest to get taxable income, and then subtract taxes to

arrive at net income Doing so, we get:

Income Statement

Now we can calculate the OCF, which is:

OCF = EBIT + Depreciation – Taxes

OCF = $7,980 + 2,130 – 2,226

OCF = $7,884

9 Net capital spending is the increase in fixed assets, plus depreciation Using

this relationship, we find:

Net capital spending = NFAend – NFAbeg + Depreciation

Net capital spending = $2,040,000 – 1,725,000 + 321,000

Net capital spending = $636,000

10 The change in net working capital is the end of period net working capital

minus the beginning of period net working capital, so:

Change in NWC = NWCend – NWCbeg

Change in NWC = (CAend – CLend) – (CAbeg –

CLbeg) Change in NWC = ($1,230 – 905) – (1,015 –

905) Change in NWC = $180

11 The cash flow to creditors is the interest paid, minus any net new borrowing,

so:

Cash flow to creditors = Interest paid – Net new borrowing

Cash flow to creditors = Interest paid – (LTDend – LTDbeg)

Cash flow to creditors = $91,500 – ($1,530,000 – 1,375,000)

Cash flow to creditors = –$63,500

12 The cash flow to stockholders is the dividends paid minus any new equity

raised So, the cash flow to stockholders is: (Note that APIS is the additional

paid-in surplus.)

Cash flow to stockholders = Dividends paid – Net new equity

Cash flow to stockholders = Dividends paid – (Commonend + APISend)

– (Commonbeg + APISbeg)

Cash flow to stockholders = $140,000 – [($145,000 + 2,900,000) – ($135,000 + 2,600,000)]

Cash flow to stockholders = –$170,000

13 We know that cash flow from assets is equal to cash flow to creditors plus cash

flow to stockholders So, cash flow from assets is:

Cash flow from assets = Cash flow to creditors + Cash flow to stockholders Cash flow from assets = –$63,500 – 170,000

Cash flow from assets = –$233,500

We also know that cash flow from assets is equal to the operating cash flow minus the change in net working capital and the net capital spending We can use this relationship to find the operating cash flow Doing so, we find:

Cash flow from assets = OCF – Change in NWC – Net capital spending

–$233,500 = OCF – (–$120,000) – (910,000)

OCF = –$233,500 – 120,000 + 910,000 OCF

= $556,500

Intermediate

14 a To calculate the OCF, we first need to construct an income statement The

income statement starts with revenues and subtracts costs to arrive at EBIT

We then subtract out interest to get taxable income, and then subtract taxes

to arrive at net income Doing so, we get:

Income Statement Sales $153,000

Costs 81,900

Other Expenses 5,200 Depreciation 10,900

Taxable income $46,600 Taxes 16,330

Net income $30,270

Addition to retained earnings23,070 Dividends paid plus addition to retained earnings must equal net income, so:

Net income = Dividends + Addition to retained earnings

Addition to retained earnings = $30,270 – 7,200

Addition to retained earnings = $23,070

So, the operating cash flow is:

OCF = EBIT + Depreciation – Taxes

OCF = $55,000 + 10,900 – 16,330

OCF = $49,570

b The cash flow to creditors is the interest paid, minus any new borrowing

Since the company redeemed long-term debt, the net new borrowing is negative So, the cash flow to creditors is:

Cash flow to creditors = Interest paid – Net new borrowing

Cash flow to creditors = $8,400 – (–$3,900)

Cash flow to creditors = $12,300

c The cash flow to stockholders is the dividends paid minus any new equity

So, the cash flow to stockholders is:

Cash flow to stockholders = Dividends paid – Net new equity

Cash flow to stockholders = $7,200 – 2,600

Cash flow to stockholders = $4,600

d In this case, to find the addition to NWC, we need to find the cash flow from

assets We can then use the cash flow from assets equation to find the change in NWC We know that cash flow from assets is equal to cash flow

to creditors plus cash flow to stockholders So, cash flow from assets is: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders

Cash flow from assets = $12,300 + 4,600

Cash flow from assets = $16,900

Net capital spending is equal to depreciation plus the increase in fixed assets, so:

Net capital spending = Depreciation + Increase in fixed assets

Net capital spending = $10,900 + 20,250

Net capital spending = $31,150

Now we can use the cash flow from assets equation to find the change in NWC Doing so, we find:

Cash flow from assets = OCF – Change in NWC – Net capital spending

$16,900 = $49,570 – Change in NWC – $31,150 Change in NWC =

$1,520

15 Here we need to work the income statement backward Starting with net

income, we know that net income is:

Net income = Dividends + Addition to retained earnings

Net income = $925 + 2,300

Net income = $3,225

Net income is also the taxable income, minus the taxable income times the tax rate, or:

Net income = Taxable income – (Taxable income)(Tax rate) Net income = Taxable income(1 – Tax rate)

We can rearrange this equation and solve for the taxable income as:

Taxable income = Net income / (1 – Tax rate)

Taxable income = $3,225 / (1 – 40)

Taxable income = $5,375

EBIT minus interest equals taxable income, so rearranging this relationship, we find:

EBIT = Taxable income + Interest

EBIT = $5,375 + 1,580

EBIT = $6,955

Now that we have the EBIT, we know that sales minus costs minus

depreciation equals EBIT Solving this equation for EBIT, we find:

EBIT = Sales – Costs – Depreciation

$6,955 = $51,000 – 39,800 – Depreciation

Depreciation = $4,245

16 We can fill in the balance sheet with the numbers we are given The balance

sheet will be:

Accounts receivable 253,000 Notes payable 189,000

Current assets $984,000 Long-term debt 1,250,000

Tangible net fixed assets$5,100,000

Intangible net fixed assets 847,000 Common stock ??

17 Owner’s equity is the maximum of total assets minus total liabilities, or zero

Although the book value of owners’ equity can be negative, the market value

of owners’ equity cannot be negative, so:

Owners’ equity = Max [(TA – TL), 0]

a If total assets are $9,300, the owners’ equity is:

Owners’ equity = Max[($9,300 – 8,400), 0]

Owners’ equity = $900

b If total assets are $6,900, the owners’ equity is:

Owners’ equity = Max[($6,900 – 8,400), 0]

Owners’ equity = $0

18 a Using Table 2.3, we can see the marginal tax schedule For Corporation

Growth, the first $50,000 of income is taxed at 15 percent, the next $25,000

is taxed at 25 percent, and the next $14,000 is taxed at 34 percent So, the

total taxes for the company will be:

TaxesGrowth = 0.15($50,000) + 0.25($25,000) + 0.34($14,000)

TaxesGrowth = $18,510

For Corporation Income, the first $50,000 of income is taxed at 15 percent, the next $25,000 is taxed at 25 percent, the next $25,000 is taxed at 34 percent, the next $235,000 is taxed at 39 percent, and the next $8,565,000 is taxed at 34 percent So, the total taxes for the company will be:

TaxesIncome = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($235,000)

+ 0.34($8,565,000) TaxesIncome = $3,026,000

b The marginal tax rate is the tax rate on the next $1 of earnings Each firm

has a marginal tax rate of 34% on the next $10,000 of taxable income, despite their different average tax rates, so both firms will pay an additional

$3,400 in taxes

19 a The income statement starts with revenues and subtracts costs to arrive at

EBIT We then subtract interest to get taxable income, and then subtract

taxes to arrive at net income Doing so, we get:

Income Statement Sales $2,400,000 Cost of goods sold 1,425,000 Other expenses 435,000 Depreciation 490,000

Interest 215,000 Taxable income–$165,000

Net income –$165,000 The taxes are zero since we are ignoring any carryback or carryforward provisions